Most investors pay scant attention to portfolio risk management. In this article we discuss the importance of risk management, and how we handle portfolio risk for the investment management clients of BWFA.
In the 1990’s, as the value of their investment portfolios rose sharply, most investors ignored the risk in their portfolios. The more risk that you took (e.g., investing in Internet startups), the higher the returns. Most investors did not correlate the outsized returns with excessive portfolio risk at the time, but most would now understand the significance, having watched their stocks lose 50% (or more) of their value in 2000-2002.
Before the downturn in 2000-2002 most investors thought an S&P 500 Index fund provided them with all the diversification they needed. They learned differently, as large capitalization growth stocks declined 45% over the three years, and $100 became $55. Managing risk is kind of like driving over the speed limit. You don’t think of the consequences until it is too late.
Professional money managers have long recognized the importance of risk management. Studies show conclusively that most of the long term return investors earn is based on how their assets are allocated, as opposed to market timing or success with hot stocks. It’s the discipline of sticking to an appropriate risk profile that pays dividends. It’s not sexy but it works. So what is an appropriate risk profile?
Model Portfolios
The appropriate amount of risk in each client’s portfolio varies by client. Clearly, a 35 year old with a steady job can tolerate a higher degree of market volatility (risk) than a 65 year old living off of portfolio income. But if each client is different, how do we manage the risk of each client’s investments in a large firm? One of the ways is by using Model Portfolios.
In the early 1990’s we developed seven model portfolios. Each Model has a different mix of assets with different risk characteristics. We then matched a model to each of our clients based on their income needs, net worth, age, goals, and our judgment of their willingness to accept risk. The seven models are: Aggressive Growth, Capital Appreciation, Conservative Growth, Growth and Income, Income and Growth, Income, and Maximum Income. By monitoring the actual mix in a client’s portfolio against their assigned Model, we can more easily maintain the risk profile appropriate for each client. Our reports are arranged so clients can monitor what’s going on, and see if we are following their Model.
The Models Versus The Market
Before we began using our Models we did extensive testing to ensure the models would meet the expected risk/return profile. However, we know that so-called “back-testing” is theoretical, and not the same as real-time investing under actual market conditions with real money and every day influences – like investor/client behavior.
A more accurate way to determine if our approach of using Models works is to look back over a full market cycle—the last 8 years—to see how our Models held up under actual conditions. We are confident that clients who do this will be very satisfied with their investment results over this period.*
Individual investors often fail because they lack the information necessary to make good decisions, but also because they don’t have the discipline and detachment necessary to manage their investments. The tremendous growth in our business is evidence that investors have reached the conclusion that it pays big dividends to have a professional investment manager handle their money.
* Investment performance of individual client accounts can vary considerably due to differences in withdrawal rates, specific investments, investment model and restrictions.